1. Chapter 4 Lecture - Consumption, Saving, and Investment

2. Consumption and Saving
The importance of consumption and saving
Desired consumption: consumption amount desired by households
Desired national saving: level of national saving when consumption is at its desired level:
Sd = Y – Cd – G
The consumption and saving decision of an individual
A person can consume less than current income (saving is positive)
A person can consume more than current income (saving is negative)

3. Consumption and Saving
The consumption and saving decision of an individual
Trade-off between current consumption and future consumption
The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate
Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time

4. Consumption and Saving
Effect of changes in current income
Increase in current income: both consumption and saving increase (vice versa for decrease in current income)
Marginal propensity to consume (MPC) = fraction of additional current income consumed in current period; between 0 and 1
Aggregate level: When current income (Y) rises, Cd rises, but not by as much as Y, so Sd rises
Effect of changes in expected future income
Higher expected future income leads to more consumption today, so saving falls

5. Consumption and Saving
Application: consumer sentiment and forecasts of consumer spending
Do consumer sentiment indexes help economists forecast consumer spending?
Data do not seem to give much warning before recessions
Figure 4.1 Consumer Sentiment, 1978Q1—2012Q1

6. Figure 4.2 Consumer Sentiment and Consumption Spending Growth, 1978Q1—2012Q1
Source: Index of Consumer Sentiment (© Thomson Reuters/University of Michigan) from research.stlouisfed.org/fred2/series/UMCSENT and updates from news releases by Reuters.com;consumption spending from research. stlouisfed.org/fred2/series/PCECC96.

7. Consumption and Saving
Effect of changes in wealth
Increase in wealth raises current consumption, so lowers current saving
Effect of changes in real interest rate
Increased real interest rate has two opposing effects
Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving
Income effect
For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving)
For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth
Empirical studies have mixed results; probably a slight increase in aggregate saving

8. Consumption and Saving
Effect of changes in real interest rate
Taxes and the real return to saving
Expected after-tax real interest rate:
ra-t = (1 – t)i – e
Calculating After-Tax Interest Rates

9. The Effects of Changes in Income and Wealth on Consumption and Saving
The permanent income theory
This distinction between permanent and temporary income changes was made by Milton Friedman in the 1950s and is known as the permanent income theory
Permanent changes in income lead to much larger changes in consumption
Thus permanent income changes are mostly consumed, while temporary income changes are mostly saved

10. Consumption and Saving Over Many Periods: The Life-Cycle Model
Developed by Franco Modigliani and associates in the 1950s
Looks at patterns of income, consumption, and saving over an individual’s lifetime
Real income steadily rises over time until near retirement; at retirement, income drops sharply
Lifetime pattern of consumption is much smoother than the income pattern
In reality, consumption varies somewhat by age
For example, when raising children, household consumption is higher than average
The model can easily be modified to handle this and other variations

11. Consumption and Saving Over Many Periods: The Life-Cycle Model

12. Consumption and Saving Over Many Periods: The Life-Cycle Model
Saving has the following lifetime pattern
Saving is low or negative early in working life
Maximum saving occurs when income is highest (ages 50 to 60)
Dissaving occurs in retirement
Bequests and saving
What effect does a bequest motive (a desire to leave an inheritance) have on saving?
Simply consume less and save more than without a bequest motive

13. Consumption and Saving Over Many Periods: The Life-Cycle Model
Excess sensitivity and borrowing constraints
Borrowing constraints mean people can’t borrow as much as they want Lenders may worry that a consumer won’t pay back the loan, so they won’t lend
If a person wouldn’t borrow anyway, the borrowing constraint is said to be nonbinding
But if a person wants to borrow and can’t, the borrowing constraint is binding

14. Consumption and Saving Over Many Periods: The Life-Cycle Model
Excess sensitivity and borrowing constraints
A consumer with a binding borrowing constraint spends all income and wealth on consumption
So an increase in income or wealth will be entirely spent on consumption as well
This causes consumption to be excessively sensitive to current income changes
How prevalent are borrowing constraints? Perhaps 20% to 50% of the U.S. population faces binding borrowing constraints

15. Duesenberry's Ratchet Affect

16. Consumption and Saving
In touch with data and research: interest rates
Discusses different interest rates, default risk, term structure (yield curve), and tax status
Since interest rates often move together, we frequently refer to “the” interest rate
Yield curve: relationship between life of a bond and the interest rate it pays

17. Yield Curve – Term Structure of Interest Rates

18. Consumption and Saving
Fiscal policy
Affects desired consumption through changes in current and expected future income
Directly affects desired national saving, Sd = Y – Cd – G
Government purchases (temporary increase)
Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption
Even true if financed by higher future taxes, if people realize how future incomes are affected
Since Cd declines less than G rises, national saving
(Sd = Y – Cd – G) declines
So government purchases reduce both desired consumption and desired national saving

19. Consumption and Saving
Fiscal policy
Taxes
Lump-sum tax cut today, financed by higher future taxes
Decline in future income may offset increase in current income; desired consumption could rise or fall
Ricardian equivalence proposition
If future income loss exactly offsets current income gain, no change in consumption
Tax change affects only the timing of taxes, not their ultimate amount (present value)
In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads to increased desired consumption and reduced desired national saving

20. Consumption and Saving
Application: How consumers respond to tax rebates
The government provided tax rebates in recessions of 2001 and , hoping to stimulate the economy
Research by Shapiro and Slemrod suggests that consumers did not increase spending much in 2001, when the government provided a similar tax rebate
New research by Agarwal, Liu, and Souleles finds that even though consumers originally saved much of the tax rebate, later they increased spending and increased their credit-card debt

21. Consumption and Saving
Application: How consumers respond to tax rebates
The new research comes from credit-card payments, purchases, and debt over time
People getting the tax rebates initially made additional payments on their credit cards, paying down their balances; but after nine months they had increased their purchases and had more credit-card debt than before the tax rebate

22. Summary

23. Investment Why is investment important?
Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle
Investment plays a crucial role in economic growth
The desired capital stock
Desired capital stock is the amount of capital that allows firms to earn the largest expected profit
Desired capital stock depends on costs and benefits of additional capital
Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf)

24. Investment The desired capital stock The user cost of capital
cost of capital, depreciation rate, and expected real interest rate
User cost of capital = real cost of using a unit of capital for a specified period of time = real interest cost + depreciation
uc = rpK + dpK = (r + d)pK

25. Figure 4.3 Determination of the desired capital stock

26. Investment The desired capital stock
Desired capital stock is the level of capital stock at which MPKf = uc
MPKf falls as K rises due to diminishing marginal productivity
uc doesn’t vary with K, so is a horizontal line
If MPKf > uc, profits rise as K is added (marginal benefits > marginal costs)
If MPKf  uc, profits rise as K is reduced (marginal benefits < marginal costs)
Profits are maximized where MPKf = uc

27. Investment Changes in the desired capital stock
Factors that shift the MPKf curve or change the user cost of capital cause the desired capital stock to change
These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf

28. Figure 4.4 A decline in the real interest rate raises the desired capital stock

29. Figure 4.5 An increase in the expected future MPK raises the desired capital stock

30. Investment Changes in the desired capital stock
Taxes and the desired capital stock
With taxes, the return to capital is only (1 – ) MPKf
A firm chooses its desired capital stock so that the return equals the user cost, so
(1 – )MPKf = uc, which means:
MPKf = uc/(1 – ) = (r + d)pK/(1 – )
Tax-adjusted user cost of capital is uc/(1 – )
An increase in τ raises the tax-adjusted user cost and reduces the desired capital stock

31. Investment Changes in the desired capital stock
Taxes and the desired capital stock
In reality, there are complications to the tax-adjusted user cost
We assumed that firm revenues were taxed
In reality, profits, not revenues, are taxed
So depreciation allowances reduce the tax paid by firms, because they reduce profits
Investment tax credits reduce taxes when firms make new investments
Summary measure: the effective tax rate—the tax rate on firm revenue that would have the same effect on the desired capital stock as do the actual provisions of the tax code

32. Table 4.2 Effective Tax Rate on Capital, 2007

33. Investment From the desired capital stock to investment
The capital stock changes from two opposing channels
New capital increases the capital stock; this is gross investment
The capital stock depreciates, which reduces the capital stock
Net investment = gross investment (I) minus depreciation:
Kt+1 – Kt = It – dKt
where net investment equals the change in the capital stock
Rewriting gives It = Kt+1 – Kt + dKt
If firms can change their capital stocks in one period, then the desired capital stock (K*) = Kt+1
So It = K* – Kt + dKt
Thus investment has two parts
Desired net increase in the capital stock over the year (K* – Kt)
Investment needed to replace depreciated capital (dKt)

34. Figure 4.6 Gross and net investment, 1929-2011
Sources: GDP, gross private domestic investment, and net private domestic investment from BEA Web site, Tables 1.1.5, 5.1, and

36. Goods Market Equilibrium
The real interest rate adjusts to bring the goods market into equilibrium
Y = Cd + Id + G goods market equilibrium condition
Differs from income-expenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market won’t be in equilibrium
Alternative representation: since
Sd = Y – Cd – G, Sd = Id

37. Figure 4.8 Goods market equilibrium

38. Goods Market Equilibrium
Shifts of the saving curve
Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect)
Example: Temporary increase in government purchases shifts S left
Result of lower savings: higher r, causing crowding out of I
Shifts of the investment curve
Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital
Result of increased investment: higher r, higher S and I 

39. Figure 4.9 A decline in desired saving

40. Figure 4.10 An increase in desired investment

41. Explain the Adjustment Process

42. Macroeconomic consequences of the boom and bust in stock prices
Sharp changes in stock prices affect consumption spending (a wealth effect) and capital investment

43. Goods Market Equilibrium
The boom and bust in stock prices
Consumption and the 1987 crash
When the stock market crashed in 1987, wealth declined by about $1 trillion
Consumption fell somewhat less than might be expected, and it wasn’t enough to cause a recession
There was a temporary decline in confidence about the future, but it was quickly reversed
The small response may have been because there had been a large run-up in stock prices between December 1986 and August 1987, so the crash mostly erased this run-up

44. Goods Market Equilibrium
The boom and bust in stock prices
Consumption and the rise in stock market wealth in the 1990s
Stock prices more than tripled in real terms
But consumption was not strongly affected by the runup in stock prices

45. Goods Market Equilibrium
The boom and bust in stock prices
Consumption and the decline in stock prices in the early 2000s
In the early 2000s, wealth in stocks declined by about $5 trillion
But consumption spending increased as a share of GDP in that period
Investment and the declines in the stock market in the 2000s
Investment and Tobin’s q (refer to link below) were correlated in 2000 and 2008, when the stock market fell sharply
Investment tended to lag the decline in the stock market, reflecting lags in the process of making investment decisions
The Q Ratio and Market Valuation: Monthly Update

46. Goods Market Equilibrium
The boom and bust in stock prices
The financial crisis of 2008
Stock prices plunged in fall 2008 and early 2009, and home prices fell sharply as well, leading to a large decline in household net wealth
Despite the decline in wealth, the ratio of consumption to GDP did not decline much

47. Figure 4.11 Real U.S. stock prices and the ratio of consumption to GDP, 1987-2012
Source: S&P 500 from Yahoo finance Web site, finance.yahoo. com; real S&P 500 calculated as S&P 500 divided by GDP deflator; GDP deflator, consumption spending, and GDP from St. Louis Fed Web site at research.stlouisfed.org/fred2 series GDPDEF, PCEC, and GDP, respectively.